Short Butterfly

The short butterfly is a neutral strategy like the long
butterfly but bullish on
volatility. It is a limited profit, limited risk options trading strategy. There are 3 striking prices involved in a short butterfly spread and it can be constructed using
calls or puts.

Short Butterfly Construction

Sell 1 ITM Call Buy 2 ATM Calls Sell 1 OTM Call

Short Call Butterfly

Using calls, the short butterfly can be constructed by writing one lower striking in-the-money call, buying two at-the-money calls and writing another higher striking
out-of-the-money
call, giving the trader a net credit to enter the position.

Limited Profit

Maximum profit for the short butterfly is obtained when the underlying stock price rally pass the higher
strike price or drops below the lower strike price at expiration.

If the stock ends up at the lower striking price, all the options expire worthless
and the short butterfly trader keeps the initial credit taken when entering the
position.

However, if the stock price at expiry is equal to the higher strike price, the
higher striking call expires worthless while the "profits" of the two long calls
owned is canceled out by the "loss" incurred from shorting the lower striking call. Hence,
the maximum profit is still only the initial credit taken.

Limited Risk

Maximum loss for the short butterfly is incurred when the stock price of the underlying stock remains unchange
at expiration. At this price, only the lower striking call which was shorted expires
in-the-money. The trader will have to buy back the call at its intrinsic value.

Example

Suppose XYZ stock is trading at $40 in June. An options trader executes a short
call butterfly strategy by writing a JUL 30 call for $1100, buying two JUL 40 calls for $400
each and writing another JUL 50 call for $100. The net credit taken to enter the
position is $400, which is also his maximum possible profit.

On expiration in July, XYZ stock has dropped to $30. All the options expire worthless
and the short butterfly trader gets to keep the entire initial credit taken of $400
as profit. This is also the maximum profit attainable and is also obtained even
if the stock had instead rallied to $50 or beyond.

On the downside, should the stock price remains at $40 at expiration, maximum loss
will be incurred. At this price, all except the lower striking call expires worthless.
The lower striking call sold short would have a value of $1000 and needs to be bought
back. Subtracting the initial credit of $400 taken, the net loss (maximum) is equal
to $600.

Note: While we have covered the use of this strategy with reference to stock options, the short butterfly is equally applicable using ETF options, index options as well as options on futures.

Commissions

Commission charges can make a significant impact to overall profit or loss when implementing option spreads strategies. Their effect is even more pronounced for the short butterfly as there are 4 legs involved in this trade compared to simpler strategies like the vertical spreads which have only 2 legs.

If you make multi-legged options trades frequently, you should check out the brokerage firm OptionsHouse.com where they charge a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the short butterfly in that they are also high volatility strategies that have limited profit potential and limited risk.

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